Right after celebrating its second birthday, proposal to change the definition of “smaller reporting company” is adopted (updated)

[This post has been updated to reflect the adopting release, which has now been posted here, as well as posted statements from the Commissioners.] The pressure has been coming from all directions—the Congress, the Treasury—indeed, there’s been nary an advisory committee that hasn’t weighed in on this topic: time for the SEC to change the definition of “smaller reporting company.” After all, the proposal has just celebrated its second birthday—has it aged like a fine wine or is it moldy and stinky like an old piece of cheese? The verdict: moldy cheese that made no one happy, but they all ate it anyway.

[This post has been updated to reflect the adopting release, which has now been posted here, as well as posted statements from the Commissioners.] The pressure has been coming from all directions—the Congress, the Treasury—indeed, there’s been nary an advisory committee that hasn’t weighed in on this topic: time for the SEC to change the definition of “smaller reporting company.” After all, the proposal has just celebrated its second birthday—has it aged like a fine wine or is it moldy and stinky like an old piece of cheese? The verdict: moldy cheese that made no one happy, but they all ate it anyway.

On Thursday, the SEC voted unanimously to amend the definition of “smaller reporting company” to allow more companies to take advantage of the scaled disclosures permitted for companies that meet the definition. (Here is the press release.) The amendments raise the SRC cap from “less than $75 million” in public float to “less than $250 million” and also include as SRCs companies with less than $100 million in annual revenues if they also have either no public float or, in a change from the proposal, a public float that is less than $700 million. The change was intended to promote capital formation and to reduce compliance costs for small public companies, while maintaining “appropriate investor protections.” The amendments become effective 60 days after publication in the Federal Register. (The SEC also voted to mandate Inline XBRL and to propose a number of changes to the whistleblower program. See this PubCo post and this PubCo post.)

The new amendments do not change any of the scaled disclosure requirements, and smaller reporting companies are allowed to comply with the SEC’s disclosures requirements on a scaled item-by-item basis. SRCs may, for example, omit some disclosures that many view as fairly onerous, including several of the otherwise required compensation tables, CD&A and, da DAH, the pay-ratio disclosure. Check out the handy table of Regs S-K and S-X scaled disclosure “accommodations” in the adopting release. SRCs can also use Form S-1 to “forward incorporate” subsequently filed information if they meet the eligibility requirements specified in the Form’s instructions. In addition, SRCs may be slow-walked into new requirements with extended phase-ins (e.g., the limited conflict minerals disclosure phase-in and proposed pay-for-performance disclosure rules discussed in this PubCo post). Notably, however, there are some requirements in Reg S-K Item 404 that are more rigorous, and SRCs must comply with those requirements.

SideBar

Because SRCs may opt for scaled disclosure on item-by-item basis, many SRCs have—and it’s likely that many newly minted SRCs will—decide to comply with some requirements on a voluntary basis. For example, SRCs are not required to include risk factors in their Exchange Act filings, but because the Private Securities Litigation Reform Act requires that, to obtain PSLRA protection, forward-looking statements must be “accompanied” by cautionary language, many companies may well elect to provide risk factors. In some cases, market expectations may drive companies to provide three years of audited financial statements, even though SRCs are required to provide only two. Similarly, SRCs are not relieved of the obligation to solicit say-on-pay votes, which will mean that, even though an SRC is not required to include a CD&A in its proxy statement, it will need to consider whether to continue to provide a CD&A, or a version of same, to explain their executive compensation philosophy and practices to support a favorable vote and secure favorable recommendations from the proxy advisory firms, such as ISS, whether under the caption “CD&A” or as part of the say-on-pay proposal itself.

Under current rules, a company qualifies as a smaller reporting company if it has either (1) less than $75 million in public float (i.e., voting and non-voting common equity held by non-affiliates) as of the last business day of its most recently completed second fiscal quarter or (2) no public float (e.g., because it has no public equity outstanding or no market price exists for its equity) and annual revenues of less than $50 million during the most recently completed fiscal year for which audited financial statements are available. Smaller reporting company status is determined annually.

Under the “public float test” in the new definition, the cap to qualify as a smaller reporting company will be raised to “less than $250 million” in public float. In addition, under the “revenue test,” a company with no public float or a public float less than $700 million could qualify as a smaller reporting company if it had annual revenues of less than $100 million during its most recently completed fiscal year. (A company that qualifies as an SRC under the public float test would qualify regardless of its revenues.) The new component of the revenue test was added to allow highly valued pre-revenue companies, such as a number of biotechs, to continue to focus on innovation and benefit from the cost savings of the scaled disclosure accommodations.

For purposes of the first fiscal year ending after effectiveness of the amendments, a company can qualify as an SRC under one of these revised “initial qualification” caps as of the date it is required to measure its public float or revenues, even if the company did not previously qualify as an SRC. However, if the company does not qualify as an SRC under the initial qualification caps (or fails to qualify thereafter as of an annual determination), it will remain unqualified until it meets other lower caps set at 80% of the initial qualification caps: under the public float test, until it determines that its public float is less than $200 million or, under the revenue test, until it has annual revenues of less than $80 million during its previous fiscal year, if it previously had $100 million or more of annual revenues, or less than $560 million of public float, if it previously had $700 million or more of public float, or both, if both are exceeded. That is, the company needs to be under the relevant lower cap only with respect to the cap or caps it previously exceeded. This structure is designed to avoid situations in which companies enter and exit SRC status due to small fluctuations in their public float or revenues.

The SEC staff estimated that, under the new definition, 966 additional companies will be eligible for SRC status in the first year, with many concentrated in the pharmaceutical products and banking industries, including “779 companies with a public float of $75 million or more and less than $250 million; 161 companies with a public float of $250 million or more and less than $700 million and revenues of less than $100 million; and 26 companies with no public float and revenues of $50 million or more and less than $100 million.” The staff estimated total annual cost savings per newly eligible registrant with a public float around the $75 million cap to be between approximately $100,000 and $300,000. In addition, the staff found that, for most of the newly eligible SRCs under the final rules, scaled disclosures may generate “a modest, but statistically significant, deterioration in the overall quality of information environment and a muted effect on the growth of the registrant’s capital investments, investments in R&D, and assets.” The change to the SRC definition was recommended in a Treasury report, as well as by numerous advisory groups, all of which have been clamoring relentlessly for relief from the burdens of disclosure and other regulation for smaller public companies. (See this PubCo post, this PubCo post, and this PubCo post.)

In another change from the proposal, the final rules also include amendments related to financial statements of acquired businesses. Rule 3-05(b)(2)(iv) of Reg S-X is being amended to increase the net revenue cap from $50 million to $100 million, allowing companies to omit financial statements of businesses acquired or to be acquired for the earliest of the three fiscal years otherwise required by Rule 3-05 if the net revenues of that business are less than $100 million.

There are also conforming amendments to the definition in Rule 12b-2 of “accelerated filer” and “large accelerated filer” to provide that qualifying as an SRC will no longer automatically make a company a non-accelerated filer (along with related changes to the cover pages of registration statements and periodic reports). That is, even though they might qualify as SRCs, companies with $75 million or more of public float would remain subject to the “accelerated filer” requirements, including the accelerated timing of filing of periodic reports and the requirement to provide a SOX 404(b) auditor’s internal control attestation. The adopting release indicates that, not surprisingly, many commenters took the opportunity to recommend that the SEC increase the public float cap in the accelerated filer definition commensurate with the cap in the new SRC definition, arguing that the costs associated with SOX 404(b) were burdensome and “divert capital from core business needs.” Although the SEC elected not to raise the accelerated filer cap, notwithstanding the admitted additional regulatory complexity, Chair Clayton did direct the staff to formulate recommendations “for possible additional changes to the ‘accelerated filer’ definition that, if adopted, would have the effect of reducing the number of companies that qualify as accelerated filers in order to promote capital formation by reducing compliance costs for those companies, while maintaining appropriate investor protections.”

SideBar

In 2015, the SEC’s Advisory Committee on Small and Emerging Companies recommended that the SEC attempt to harmonize the jumble of rules applicable to the various categories of small companies and, specifically, that the SEC increase the threshold for “accelerated filers” to include companies with a public float of $250 million or more, but less than $700 million, with the result that the requirement to provide an auditor attestation report under SOX 404(b) would no longer apply to those companies. (See this PubCo post.) However, in the release proposing the change to the SRC definition in 2016, the SEC expressly rejected that Committee recommendation on the basis of a 2011 staff study, which found

“no specific evidence that any potential savings from exempting registrants with public floats between $75 million and $250 million from the auditor attestation provisions of Section 404(b) would justify the loss of investor protections and benefits to registrants from such an exemption. Rather, the staff found that accelerated filers (including those with a public float between $75 million and $250 million) that were subject to the Section 404(b) auditor attestation requirements generally had a lower restatement rate than registrants that were not subject to the requirements. Moreover, the staff found that the population of registrants with public floats between $75 million and $250 million did not have sufficiently unique characteristics that would justify differentiating this population of registrants from other accelerated filers with respect to the Section 404 auditor attestation requirements.”

The proposing release also observed that subsequent academic research on this topic was mixed. As a result, the SEC did not propose to raise the accelerated filer public float threshold or to modify the SOX 404(b) requirement as part of that proposal. The SEC did, however, request comment on the issue.

Since the proposal was issued in 2016, there has been a torrent of criticism of the application of SOX 404(b) to smaller companies, including from the Committee, which, in its final report in 2017, reiterated its recommendation. In particular, SOX 404(b) has recently been scrutinized as a significant contributor to the type of regulatory overload that some argue has deterred companies from conducting IPOs. At a July 2017 hearing of the Subcommittee on Capital Markets, Securities, and Investment of the House Financial Services Committee, a number of the witnesses trained their sights on SOX 404(b), arguing that it was too time-consuming and expensive for smaller companies, diverting capital from other more important uses such as R&D. In addition, the definition of “internal control” was characterized as too broad, and the scope of “attest” imposed by the PCAOB was too exclusive. According to another witness, however, an EY report showed that, following the effectiveness of the SOX attestation requirement, from 2005 to 2016, the number of financial restatements declined by 90%, and the aggregate amount of net income involved in restatements declined from $6 billion to $1 billion. Initially, in the first two years after SOX 404(b) went into effect, there were over 1,000 restatements in each year. If SOX 404(b) were eliminated, a witness speculated, the result could very well be that there is no beneficial effect on the number of public offerings, but that the risk of financial scandal has dramatically increased. (See this PubCo post, this PubCo post and this PubCo post.)

Chair Clayton viewed the new amendments as a step in the direction of facilitating capital formation by recognizing that a “one-size regulatory structure for public companies does not fit all.” He did not believe that the scaled disclosure requirements would impair investor protections: these companies will continue to have “substantial public disclosure requirements, will remain liable for their required disclosures, as well as any materially misleading statements, and will continue to be subject to the Division of Corporation Finance’s filing review process.” Moreover, these scaled disclosure requirements are “almost always substantially higher” than those applicable to private companies.

But here’s where the moldy, stinky part comes in: none of the other Commissioners seemed to view the change to the SRC definition as particularly consequential on its own and, none was happy, except probably the Chair, with the Solomonic decision regarding the “accelerated filer” definition. (See this PubCo post.)

Commissioner Stein was not confident that, based on the data, the rule change would accomplish its goal of promoting capital formation and reducing compliance costs and thought it could actually lead to higher costs of capital because of the reduction in disclosure. In essence, she did not believe that the number selected as the new cap had been adequately studied to be sure that it was the smallest increase needed to achieve the goal. In addition, she contended, it had not been shown that the regulatory burden at which the rule was directed actually discouraged companies from accessing the public markets (see, e.g., this PubCo post); however, she maintained, it has been shown that investors apply a discount where companies provide reduced disclosure. The rules, she argued, should be data driven, but these changes were not.

Moreover, Stein found the Chair’s direction to provide recommendations regarding the accelerated filer definition and potential reduction in the number of companies subject to SOX 404(b) to also be problematic. Citing the 2011 staff study, she viewed SOX 404(b) as a critical investor protection, pointing out the evidence showing that companies subject to 404(b) had a lower rate of financial restatement and lower cost of capital as a result of increased investor confidence. Her preference was for a concept release to consider various views on the issue of SOX 404(b) instead of moving directly to a proposal. Nevertheless, despite her misgivings, she supported the proposal because SRCs have choices about the level of disclosure they can provide. She would also have welcomed a staff study of the results of implementation of the rules, but did not win the day on this point.

For the reasons enumerated by Commissioner Stein, Commissioner Jackson likewise found the rule change generally unobjectionable, but took issue with the underlying message that cutting red tape is the secret to helping small companies go and stay public. Rather, he contended that there was no evidence in support of that view and he was “unprepared to make policy on the basis of that assumption going forward.” Instead, the evidence supported the conclusion that the cost of going public was much more significant and that reductions in regulation can increase the cost of capital and make retail investors more wary of investing in small companies. He and his staff will be studying the effects of reduced disclosure on fraud and the cost of capital for future policymaking. In addition, he pointed out that prior efforts to reduce regulation did not result in the predicted “torrent of IPOs.” He also argued that the data did not support the idea that changes to the accelerated filer definition would be beneficial for companies or investors, as the costs of 404(b) compliance had declined and investors found the auditor’s attestation beneficial, pointing again to the staff’s 2011 study. Unless he saw “robust and reliable economic analysis” supporting “the notion that making changes to our rules under Section 404(b) would serve any part of our mission of investor protection, fair markets, and capital formation,” he would “remain extremely concerned about the possibility of any exemptions to those rules.”

In his last open meeting appearance, Commissioner Piwowar expressed his “disappointment” with the action to be taken, but for the opposite reason: he didn’t think it would accomplish much without a contemporaneous change to the accelerated filer definition to limit the application of SOX 404(b)—without that change, the new rules were “equivalent to a technical or conforming amendment,” more like “a sidecar without a motorcycle.” Instead, the SEC had missed an opportunity for “serious reform oriented toward capital formation.” He could foresee only modest effects from the rule change (compliance cost savings) but little effect on capital formation. Nevertheless, he saw no harm to it, and so he supported the proposal.

Commissioner Peirce (apparently pronounced “purse”) also voted in favor, but agreed with Commissioner Piwowar that this change to the SRC definition was just a “cautious beginning—a welcome prelude to more meaningful future steps, but not on their own likely to make a definitive difference for small companies considering going public.” Many commenters had argued that funds spent on the attestation would be much better spent on R&D and other investments, and she, like Piwowar, would have preferred that action be taken on SOX 404(b) now. Also, she believed that the change, without a comparable change to the accelerated filer definition to better align the definitions, could be confusing to registrants. In her view, the real change would come when the SEC tackled SOX 404(b).

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